3 1 Introduction Carry trades are investments where investors borrow rom low interest rate capital markets and invest in high yield markets to proit rom the interest rate dierential. Investors take the risk o devaluation o the investment currency. The volume o these speculative investments increased substantially in emerging markets prior to the inancial crisis. Especially Central and Eastern Europe (CEE) attracted a surge o un-hedged cross-border investment and lending. As this involves the purchase o assets using oreign currency, carry trades might have contributed to asset market booms in CEE (Galati et al., 2007). The aim o this paper is to analyze i and why carry trades to CEE were lucrative in the run-up to the latest crisis. To analyze determinants o carry trade returns in CEE, I apply the indings o the most recent empirical carry trades literature to my sample o CEE economies. Following Brunnermeier et al. (2009) carry trades are lucrative as long as liquidity conditions are avorable. Interest rate dierentials uel returns but also increase the crash risk o the investment currency. An unwinding o carry trades is caused by risk aversion in inancial markets and the resulting unding constraints. Clarida et al. (2009) add that carry trade returns are related to periods o low exchange rate volatility. My contribution to the literature is twoold. First, I test the main determinants ound in the carry trade literature or the CEE economies. Here, I ollow the idea o Minsky (1986) that risk-taking is most pronounced in an upswing o a business cycle. Thereore, in contrast to previous studies, I distinguish between boom and bust in my analysis. Second, I discuss whether exchange rate strategies in CEE aect carry trade returns. To my knowledge the impact o the exchange rate regime has not yet been examined in the carry trade literature. The paper is organized as ollows. I start with an explanation o carry trades and analyze excess returns and risks o carry trades to CEE rom 1999 to Then I investigate 2

4 determinants o carry trades. I ind that liquidity conditions, interest rate dierentials, risk appetite and exchange rate stability uel carry trade returns (and thereore short-term asset markets). The last section concludes. 2 Carry Trades and Exchange Rate Risk 2.1 Uncovered Interest Rate Parity and Carry Trade Returns There are two prominent ways o carry trading. First, investors borrow rom a low interest rate capital market and invest in a (mostly) short-term asset (bank deposits, government papers or risky assets such as stocks) in high yield markets to seek or arbitrage proits that stem rom the interest rate dierential. As long as the investment currency does not depreciate against the unding currency proits are positive (Galati et al., 2007). A second strategy is to exploit the orward premium (Brunnermeier et. al., 2009; Burnside et al., 2009). This is the dierence between the orward exchange rate and the spot exchange rate o two currencies. I a currency is assumed to depreciate against another currency because the orward rate is higher than the spot rate, it has a orward premium and is likely to be sold or becoming the unding currency. Contrary, i a currency is assumed to appreciate having a orward exchange rate that is below the spot exchange rate, it has a orward discount and may become the target o investors. This is then the investment currency. Both strategies lead to similar outcomes. Currencies with low interest rates should have a orward premium and currencies with high interest rates should have a orward discount or the carry trade to be lucrative. Then borrowing in currencies with low interest rates and lending in currencies with high interest rates is similar to buying currencies at a orward discount and selling them on orward premium. 3

5 Carry trades are commonly used by hedge unds and other inancial institutions in orm o leveraged portolios to make high short-term proits (Galati and Melvin, 2004). On the other hand, also private households and investors bet on the interest dierential without leverage to diversiy portolios or inance domestic assets. Especially in emerging markets the private sector oten sets up carry trades through the bank-lending channel. Then oreign denominated borrowing increases. While leveraged carry trades o large institutions may be unwound quickly in case o rising depreciation expectations, household s oreign exposure may not i used to invest in illiquid assets such as housing. Households or irms deault on loans in case o sudden depreciation (Galati et al., 2007). To model the returns o a carry trade strategy, I let e t be the natural logarithm o the nominal exchange rate (units o investment currency in terms o unding currency). Let i t be the natural logarithm o the unding interest rate and i * t the natural logarithm o the CEE investment interest rate in time t. Then r t 1 is the return on investment in t 1 rom borrowing at i t in one currency and investing at i * t in the other currency. 1 * r t 1 ( it it ) et 1, with et 1 et 1 et A positive e t 1 represents a depreciation o the investment currency. According to the uncovered interest rate parity (UIP) condition, which assumes perect capital market transmission, the interest rate dierential o two countries is equal to the expected exchange rate changes between the respective currencies. For instance, when investors expect an appreciation o the Hungarian orint HUF against the Swiss ranc CHF, they are indierent 1 it is the nominal interest rate. 4

6 between investment in Hungary and Switzerland i the interest rate in Switzerland is higher than in Hungary to compensate or the expected appreciation o the HUF. I, or any reason, the Hungarian interest rate was higher than the Swiss interest rate despite the appreciation expectations o the HUF against the CHF, investment would be made in Hungary. Due to capital inlows Hungarian interest rates would converge (instantly) towards the Swiss interest rates and the exchange rate would appreciate towards its expected value. Thereore, the expected returns o investment in Hungary and Switzerland should be equal because, given UIP, the higher-yielding currency always tends to depreciate against the lower-yielding currency. Following UIP E t r t 1 0, which means that the expected returns o the carry trade strategy are zero. But to engage in carry trades investors expect that a given interest rate dierential between two countries is not oset by the exchange rate movements. Thus, carry traders expect a higher yield rom the riskier currency speculation than rom risk-less investment. Then t r t 1 0 carry trade in t 1. E in t. I r 0, there is actually an ex post excess return rom t 1 Empirically UIP can hold in the long-run (Flood and Rose, 2002; Chinn and Meredith, 2004). But many studies ound that in the short-run excess returns are possible and UIP ails (Flood and Rose, 2002; McBrady, 2005). In act, high-yielding currencies oten appreciate against low-yielding currencies. Thus, currency carry trades can bring about excess returns. Empirically carry trade returns are even positive on average. This is reerred to as orward premium puzzle in the carry trade literature (Burnside et al., 2009). 5

7 2.2 Carry Trade Returns and Crash Risk: Descriptive Statistics and UIP Investment currencies are currencies o high yielding emerging market economies such as the Hungarian orint ( HUF ) or the Polish zloty ( PLN ) in CEE. The unding currencies are low interest rate currencies such as the Swiss ranc (CHF ), Japanese yen ( JPY ), the euro ( EUR ) or the US dollar (USD ). For institutional investors large interest spreads to the USD and JPY may have been o interest in CEE. However, I ocus on the CHF and EUR in my analysis. Particularly, CEE households and investors speculated on the interest rate dierential using EUR or CHF rom 2003 to 2007 (Galati et al., 2007; Saunders, 2007; and Rosenberg and Tirpak, 2008). I see mainly two reasons: First, the CEE interest rate spreads to the euro area and Swiss interest rates were considerable. Second, the dominance o European (e.g. Austrian, German and Swiss) banks in the markets and the geographical proximity allowed or an easy access to these currencies. To analyze excess returns rom EUR and CHF carry trades to Estonia (EE), Bulgaria (BU), Latvia (LV), Lithuania (LT), Romania (RO), Slovenia (SI), Slovakia (SK), Czech Republic (CZ), Poland (PL) and Hungary (HU), I take daily exchange rates or each country s currency to the EUR and CHF rom Datastream and monthly money market rates (3-month interest rates) rom the International Monetary Fund s International Financial Statistics (IFS). The dataset starts in January 1999 and ends in December Table 1 shows the averages o quarterly indicators or excess returns and risks o carry trade rom 1999 to Column 2 o Table 1 indicates that or Hungary, Slovakia, Romania and Poland the average interest rate dierentials i i ) with respect to interest rates in the ( * t t unding economies are the largest o the group o CEE economies. Column 3 shows the 6

8 average quarterly exchange rate changes. I the investment currency depreciates on average, e t 1 is positive (and vice versa). The average excess returns r t 1 rom borrowing in CHF or EUR and investing in CEE currencies can be ound in Column 4. The calculations o these carry trade returns are based upon log daily exchange rate changes to the EUR or CHF in each quarter to compare interest rate dierentials (per quarter) and exchange rate data at the same requency. In general, the returns are higher with respect to the CHF. Average carry trade returns are particularly high or Hungary, Romania, Slovakia and Poland. For these countries the descriptive statistics suggest that trades had a proit opportunity by buying CEE assets using oreign currency. Only Slovenia s average excess return per quarter with respect to the euro area is negative, because its average interest rate dierential is smaller than the depreciation o the tolar against the EUR. The Sharpe (1994) ratio 2 is a commonly used indicator to calculate the ex ante and ex post attractiveness o investment (Burnside et al., 2007). Investors use Sharpe ratios to decide on proitability by estimating expected excess returns per units o risk in an investment. The ex ante Sharpe ratio S is deined as E( rt 1) S, s( E( r )) t 1 with E ) being the expected excess returns rom carry trade. s ) is the standard ( r t 1 deviation o the expected excess returns r t 1. The Sharpe ratio indicates that when excess ( r t 1 2 According to Eling and Schuhmacher (2007), the Sharpe ratio is an eicient measure to evaluate investment strategies. 7

9 returns are high carry trades are attractive given that the volatility o excess returns is low in this period. Ex post Sharpe ratios can be calculated using ex post data to evaluate whether the carry trade was proitable. In Table 1 ex post Sharpe ratios S are calculated as ratios o average quarterly excess returns (Column 4) and the standard deviations o quarterly excess returns (Column 5) as observed in the data rom 1999 to The data indicates that Hungary, Slovakia, Estonia and Romania were the most lucrative markets or carry traders in CEE in this period. Sharpe ratios are larger than in other countries because excess returns are high and relatively stable (Column 6). While Estonia has low excess returns, Sharpe ratios are high due to low volatility o returns. Because average excess returns o carry trades rom the euro area to Slovenia are negative, the Sharpe ratio is negative as well. An analysis o skewness 3 o exchange rate changes provides evidence o how exchange rate changes are distributed and is an indication o risks o carry trades. For univariate data e,..., 1, e2 et skewness or each quarter skew is deined as skew T 3 ( et e) t 1, 3 ( T 1) s with e being the mean o exchange rate changes in the quarter, s the standard deviation o daily changes, and T the total number o daily exchange rate changes in the quarter. Symmetric data, e.g. which is normally distributed, would have a skewness o zero. Thus the average and median o exchange rate changes is equal. A negative skewness implies that a 3 Skewness is the third standardized moment o a random variable and a standard measure to describe probability distributions. 8

11 calculated (the denominator would be zero as the standard deviation o exchange rate changes is zero). Carry trades are lucrative i the interest rate dierential between the investment and unding currency is on average not oset by a depreciation o the investment currency as suggested by UIP and allows or carry trade returns. To test this econometrically or the CEE countries rom 1999 to 2009 I analyze whether interest rate spreads between CEE and the euro area or Switzerland in quarter t have predictive power or the excess returns on investment r k, in quarter t. This regression is known to signal proitability throughout the entire carry trade literature. With respect to each unding currency, I estimate a panel regression model with ixed-eects that account or country-speciic unobserved heterogeneity in CEE. 4 The regression takes the orm (, (1) r k, t b0 b1 ik, t it ) uk k, t where r, is the excess return in quarter t rom borrowing at interest rate k t i t in the unding currency ( CHF or EUR ) and investing at interest rate i, in the CEE countries k t currencies k in quarter t. Further, the error term. b 0 is the constant, uk captures the ixed eect and k,t is 4 The standard panel unit root tests (Pesaran-Shin, Levin Lin Chu, Breitung, Fisher-type) conirm that the data used in this paper (excess returns, stock movements, interest rate spreads, skewness, vix as well as dvix) is stationary. Thus, I can use least squares regressions. 10

12 Table 2: Carry trade returns regressed on interest rate dierentials rk, t 1 CHF b (0.302) EUR b (0.223) rk, t (0.269) (0.135) rk, t (0.189) (0.127) rk, t (0.225) (0.130) rk, t (0.232) (0.116) rk, t (0.218) (0.114) Source: Datastream Standard errors in parentheses. Quarterly data. Table 2 shows the impact o the interest rate dierential on carry trade returns in periods ahead. The coeicients b 1 on the interest rate dierential are positive and signiicant as indicated by the standard errors in parentheses. Following UIP the coeicients should be zero or insigniicant. However, the data suggests that interest rate dierentials are on average positive predictors or CHF and EUR carry trade returns or up to one year with respect to the euro area interest rate, and up to nine months with respect to the Swiss interest rate. This is a violation o UIP. Thus, interest rate spreads to the euro area and Switzerland made purchases o CEE assets (bonds, stocks, equity) using CHF or EUR more lucrative than using CEE currencies. There are three plausible explanations. First, the CEE economies were expected to catch-up to the EU, which typically goes along with a productivity-driven appreciation o their currencies (DeGrauwe and Schnabl, 2005). Second, many CEE countries intervene in the oreign exchange rate market to stabilize exchange rates against the EUR. Hence, investors did not expect sharp depreciations over this period. And third, Swiss and EMU nominal interest rates (and inlation) were relatively low rom 2002 to In this respect, Homann and Schnabl (2011) and Homann (2010) argue that easy monetary policies in advanced economies contributed to buoyant capital inlows and investment booms in emerging market economies which caused an appreciation o their currencies. As higher inlation in CEE prevented nominal interest rates to ully converge with the capital inlows, an interest rate spread remained, which made the carry trade lucrative. 11

14 dierentials, exchange rate changes are urther way rom a normal distribution which is assumed to be a sign o crash risk. The predictability alls with the length o the prediction horizon. Thus, high interest rate spreads contribute to carry trade returns, while they increase the crash risk (skewness) o CEE currencies. 3 Risk Aversion and Business Cycle In times o inancial distress when risk-taking is depressed and investors ace losses in inancial markets (e.g. the recent inancial crisis), the reallocation o capital restricts unding on markets (Minsky, 1986). Then, carry trade unwinds and short-term assets are sold (Brunnermeier et al., 2009; Clarida et al., 2009). I use the VIX as indicator or risk aversion and unding constraints in inancial markets. The VIX is the Chicago Board Options Exchange Market Volatility Index which captures expectations or S&P 500 stock market volatility. The VIX in t 0 is high when investors anticipate large movements in the S&P 500 in either direction until t 1 (which is a month later). Investors actively hedge (via sell and put options) expected market volatility so that option price volatility and with it the VIX increase. Thereore, the VIX is considered an index or expected inancial market (volatility) risk. It is reerred to as ear index (Brunnermeier et al., 2009). The VIX is only low when investors perceive neither signiicant downside risk nor signiicant upside potential in the S&P. Then US markets are relatively stable. Although the VIX seems to be unrelated to the markets in CEE, previous studies have shown that it is a good indicator or global risk-taking on equity as well as credit markets (Collin-Duresne et al., 2001). The indicator rises in periods o inancial turbulences and crisis such as the Russian lu o 1998 and is highly correlated with the risk premium in sovereign 13

15 credit deault swaps (Brunnermeier et al., 2009; Pan and Singleton, 2008). The rationale or using this measure is that an increase in expected US inancial market volatility spills over to other markets, e.g. the euro area or Switzerland or a common actor drives volatility in both markets. When US markets hike or all, capital redemption restricts unding o investment elsewhere. The reasoning is as ollows. Assuming a carry trader holds an investment currency in orm o a short-term asset, a rise in expected inancial market volatility as expressed by an increase o the VIX creates uncertainty in markets and leads to asset sales. On the one hand, when stark increases o the S&P are expected, CEE investment may be less lucrative relative to e.g. US investment. On the other hand, when the S&P is expected to all sharply, this signals a possible crisis and drying up liquidity. Thereore, a higher VIX signals depressed risk appetite in international inancial markets. Investors reassess the proitability o investment projects and lenders restrict unding (especially when inancial markets anticipate a downside risk). Then capital lows to CEE can reverse and oreign borrowing in CEE is restricted. Carry trades unwind. This can trigger a devaluation o the CEE currency and losses rom carry trades. Thus, carry trades unwind endogenously as a result o reallocation and reorganization o investment projects in the market. The building up o carry trade during periods o easy liquidity conditions is ollowed by a crash when liquidity conditions dry up because risk appetite in inancial markets is depressed. Following Minsky (1986) s theory o inancial instability risk appetite o inancial markets is particularly pronounced during the upswing o a business cycle. Thereore, risky investment such as carry trades has to be related to the business cycle. Returns are large when the country with the investment currency is in the upswing o a business cycle or the country 14

16 with the unding currency experiences a bust. In both cases unding interest rates are relatively low and interest rate dierentials are high (Clarida et al., 2009). Thereore, it is sensible to distinguish dierent periods in the analysis. To do so, Figure 1 illustrates the development o CEE stock markets and the VIX. The data is taken rom Datastream. Except or a small spike in 2000, CEE stock markets were relatively stable rom 1999 to The all shares indices started to hike in 2003 or 2004, shortly beore the irst CEE countries joined the EU. Depending on the CEE country, the stock market boom came to an end in early (e.g. in EE) or late 2007 (e.g. in CZ). Then, all shares stagnate until they dropped sharply in mid or late The VIX went along with the stock market in CEE. The ear index started to all in mid 2003 until the end o During this period it was at a low level. In early 2007, the VIX rose slowly. This was a irst sign o the coming turn-around. The VIX climbed until late 2007 when it moved up heavily. It remained at high levels until the end o 2009 and luctuated more strongly. 15

17 Figure 1: VIX and stock markets in CEE rom 1999 to VIX (l.h.s.) Boom Crisis CEE shares (r.h.s.) :01= Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 0 Source: Datastream CBOE VIX, CEE all shares data (2004:01=100). Thus, in the ollowing I concentrate on our dierent periods. I analyze the ull sample ranging rom 1999 to Second, I ocus on the period rom 2004 to This period is o particular interest in this paper as it covers the latest CEE asset and credit boom-and-bust cycle (Figure 1). This period can also be seen as EU period as most economies in my sample joined the EU in May Next, I distinguish between boom and bust period. To make sure the latter period captures the turn-around in every CEE economy I generously split the sample in hal. Thus, the third estimation period represents the CEE boom period ranging rom 2004 to 2006 and the orth period covers the global inancial turmoil that started in early I do not urther consider the period because it can neither be considered a 5 The results remain unchanged when splitting the sample one or two quarters earlier and later, depending on when you might consider the start o the boom or crisis period. 16

18 stable boom period nor a bust period. There was uncertainty due to the burst o the dot-com bubble in 2000 and institutional changes in CEE in preparation or EU membership. 6 To estimate the eect o the VIX on carry trade returns in CEE, I use quarterly averages o the VIX (in line with the other data). Excess carry trade returns with respect to each unding currency (CHF and EUR ) are regressed on changes in the VIX and the lagged interest rate dierentials. Thus, the VIX is assumed to explain parts o UIP ailure. The ixedeect panel regressions take the orm r k, t b0 b1 ( ik, t 1 it 1) b2 VIX t uk k, t, (3) where r, is the excess return in quarter t rom borrowing at interest rate k t it 1 in the unding currency ( CHF or EUR ) and investing at interest rate ik, t 1 in the CEE countries currencies k in quarter t 1. VIX t is the change in the VIX rom quarter 1 the constant, uk captures the ixed eect and k,t is the error term. t to t. b 0 is Table 4 shows the results or an impact o risk appetite in inancial markets and interest rate dierentials on carry trade returns with respect to the CHF and EUR or the dierent estimation periods. First, the results in the third column o Table 3 reconirm the indings in Table 2. For the whole sample, interest rate dierentials have a signiicant impact on carry trade returns as explained in section The impact o the interest dierential is larger ater 2004 as seen in the period. 6 The period yields results similar to those o the ull sample ( ) which also includes booms and busts. 17

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